Who’s to Blame for the Financial Crisis?

After interviewing hundreds of people the president’s Financial Crisis Inquiry Commission (a month late) has released its mammoth report on the causes of the financial crisis and arrived at what I think can only be considered a cop-out: everybody’s to blame—you, me, Republicans, Democrats, the Fed, regulators, Congress, bankers, consumers, foreign investors, everybody. Such a finding provides no clear guidelines for action. It is oracular rather than analytic.

There is dissension in the ranks. The commission was split, essentially along party lines, and the minority has produced its own report. The HTML text is here.

The minority report finds ten causes of the crisis:

  1. Credit bubble
  2. Housing bubble
  3. Nontraditional mortgages
  4. Credit ratings and securitization
  5. Financial institutions concentrated correlated risk
  6. Leverage and liquidity risk
  7. Risk of contagion
  8. Common shock
  9. Financial shock and panic
  10. Financial crisis causes economic crisis

The short version is that regulatory error (not too much or too little regulation but the wrong regulation) compounded by mammoth overseas capital flows were the smoking gun in the financial crisis. IMO the most significant finding in the minority report is that it absolves the Community Reinvestment Act and the repeal of Glass-Steagall from blame. The former is an article of faith among many on the right while the latter has much the same role for the left.

Mish Shedlock has an even terser explanation, assigning just three causes:

The actual cause of the financial crisis is easy to explain.

  1. Loose monetary policies at the Fed
  2. Fractional Reserve Lending
  3. Congress willing to spend more money that it takes in

Had there not been Fractional Reserve Lending, and had the Fed not cut interest rates to absurd levels while fostering a “too big to fail” attitude at banks, this would not have happened. Perpetual Congressional budget deficits and the Fed’s willingness to finance those deficits too cheaply is icing on the “what happened” cake.

which comports more closely with the actual meaning of a cause as things that are necessary and sufficient for something to occur.

Barry Ritholtz demurs; he’s got a longer, more involved explanation.

In my opinion to identify what caused the financial crisis you’ve got to consider fiduciary responsibility. When viewed through this lens Mish’s argument becomes all the stronger. The main culprit was the Congress which placed impossible burdens and mutually contradictory mandates on the Fed, the Fed for exhibiting overweaning arrogance, and Congress and regulators in conjunction for allowing fractional reserve lending to grow completely out of bounds.

I won’t absolve bankers of actual wrongdoing; details of this are coming out even now but I strongly suspect that actual wrongdoing was contributory rather than causal.

I’m not entirely convinced by the commission’s minority’s argument that regulation wasn’t a primary cause because the financial crisis wasn’t isolated to the United States. I think that the widespread character of the financial crisis merely demonstrates that banks are interconnected and that banking regulators are subject to the same temptations everywhere.

There are two forms of regulatory capture. In the first form those being regulated become de facto responsible for their own regulations: they write the rules, pick who their regulators will be, and decide what is or is not an infraction. The second form, cognitive capture, is even more insidious. In the case of cognitive capture those being regulated don’t need to write the rules because the regulators identify with those they’re tasked with regulating, consider their interests first, and are predisposed to tread lightly on them.

I think we suffer from both forms of regulatory capture and the only remedy is to change the incentives of regulators. Failing that we’ll merely repeat the errors of the past until the entire system collapses in an Argentina, Zimbabwe, or Weimar-style loss of confidence. Then, having wreaked fantastic misery, the entire merry minuet can begin again with a combination of old and new players.

20 comments… add one

  • I think we suffer from both forms of regulatory capture and the only remedy is to change the incentives of regulators.

    Really?

    Being too big to fail is okay then, we just need to regulate these big behemoths better. Do I understand you correctly?

  • michael reynolds

    Lovely. Not only are economists useless at telling us what will happen 6 months or a year down the road, and useless at reaching any sort of consensus on the results of various current policies, now they can’t even do the autopsy and come up with a cause of death.

    Astrologers vs. Economists, who do you trust?

  • john personna

    Being too big to fail is okay then, we just need to regulate these big behemoths better. Do I understand you correctly?

    Do you really think that is an original question Steve? Surely you’ve been around for the last few years when the choices were pretty much break big things up to small things that can fail, or regulate big things so they don’t.

    (Maybe you’ll recast your comment now, call me names, and say I didn’t read it.)

  • john personna

    BTW, I’m with Ritholtz and Calculated Risk that this is a much better report than we could have expected.

    Steve is ravin’ because it calls out that lack of regulation.

  • Shall we say necessary but not sufficient? We have multiple problems. The bigger the bank the happier the Congress (big banks contribute more). Same with regulators.

    However, Congress can pass all the laws it wants but if the regulators won’t enforce them it’s just a meaningless exercise.

  • In my opinion to identify what caused the financial crisis you’ve got to consider fiduciary responsibility. When viewed through this lens Mish’s argument becomes all the stronger. The main culprit was the Congress which placed impossible burdens and mutually contradictory mandates on the Fed, the Fed for exhibiting overweaning arrogance, and Congress and regulators in conjunction for allowing fractional reserve lending to grow completely out of bounds.

    How would you test your hypothesis? I’d look to Canada for a counterfactual. The Bank of Canada was not too much out of step, in terms of fiscal policies when compared to the Fed. I don’t know enough about how arrogant the Bank of Canada Governor was in comparison the the Chairman of the Fed, but if the actually policies between the two nations were not drastically different then we can conclude the arrogance displayed by the Fed was really a driving factor or that all of the variance that we see between the outcomes in the two nation’s housing markets can be found in the small differential that exists between Canadian and US monetary policy and it is a small differential because of the high degree of interconnectivity between the US and Canadian economies. Canada doesn’t have the policy latitude to set monetary policy in complete isolation from US monetary policy.

    While on the subject of international comparisons, what is glaring is that the Canadian system doesn’t have a tax deduction for mortgage interest deduction and yet has a higher level of home ownership than the US and their Federal Government didn’t impose an unfunded mandate on their banking system to loan money to unqualified borrowers in order to boost minority home ownership rates. Further, the scale of mortgage securitization in Canada is minuscule compared to the US for Canadian banks hold onto the mortgages they write. The Canadian banks were left to focus on what they know – how to identify good credit risks and how to make low risk loans and the result is a healthier real estate market in a nation with a higher rate of home ownership than the US. The US government imposed social policy goals onto the financial system and thereby distorted economic decisions that were being made. The US, through Freddie and Fannie, created incentives to book new loans and offload them to bondholders instead of keeping them within an institution’s loan portfolio and this mechanism distorted financial decision making criteria.

    Expanding beyond the housing crisis to the broader question of the financial crisis, I’m not convinced by the minority report’s contention that “the legal and regulatory structure of how the markets must operate” had little influence in terms of outcome. I don’t doubt that international capital flows were an essential ingredient in this witch’s brew but “the rules of how the game is played” can serve to mitigate the influence of international capital flows. Again, look to see how other nations dealt with capital flowing into their nations.

  • Maxwell James

    I think Mish’s critique is compelling. But his prescriptions are moronic and nakedly ideological – the kind that suggest he had a solution in mind before actually examining the problem. If a three-legged stool shows a tendency to tip over, you don’t fix it by chopping off all three legs.

  • sam

    Maybe there’s just too damn much money around.

  • john personna

    What the heck? Tango likes Canadian comparisons now? I thought you told me our cultural and ethnic differences make that impossible!

  • What the heck? Tango likes Canadian comparisons now?

    It’s a validation argument. If you pose a hypothesis, one way to test it is to look for similar processes which yield different outcomes. If you posit that A+B+C = “Outcome”, then if we see that A+B+C=”Marginally Different Outcome” in another country we have a basis to infer that A+B+C=”Outcome” is not accurately describing the relationship.

    I thought you told me our cultural and ethnic differences make that impossible!

    That’s an interesting point but I don’t know how much weight to put on this in terms of explaining variance. It’s possible that these factors have some explanatory value but I tend to favor regulatory rules as having greater influence.

    Canadian monetary policy is kind of yoked to American monetary policy because of the high level of economic integration that exists between the US and Canada. Of course they’re not identical, but they’re also not completely isolated from each other and the level of integration is higher than what we see from our other trading partners. So if monetary policy is the driving force here then we should expect similar outcomes and we didn’t see that. Where there was difference was in the realm of policy with respect to lending, bank oversight, capital leverage ratios and mortgage securitization, even with asset values in Canada rising at the same time as they were in the US and other nations. Capital inflows boosted the housing markets in a number of nations. Ireland, Spain and the US are going through the meatgrinder. Canada and Australia, not so much. What I’m saying is that if you want to understand the phenomena better it helps to look outside the US experience and try to understand the larger picture and see if one can develop a model which better explains the international variance we’re seeing.

  • michael reynolds

    I realize this is rude, but I’m going to say it anyway: I don’t think any of you really knows what you’re talking about on economic matters.

    I think that’s because economics isn’t really a science.

    When something as well-documented as the events of the last two years occurs, and equally well-credentialed experts cannot reach a conclusion as to the cause, and the differences between them are consistent along ideological lines, and indeed the entire study of economics seems incapable of reaching consensus on much of anything from the first cave-man rock exchange up through the current situation, and all this despite a great vomiting forth of statistics, and this situation does not seem to change over time but remains true to ideological form, then you know what? That ain’t science.

    I always suspected this. And the whiff of b.s. grew more pungent when I realized you guys presuppose the existence of rational man — a creature as mythical as socialist man, or for that matter, Piltdown man.

    Just because you have numbers does not make it a science. Phrenology had numbers. Astrology has numbers. If you cannot prescribe, and you cannot describe, and all that you say is shaded by considerations of self-interest, ideology and untested assumption, what you have there is not science, it’s theology.

  • Maxwell James

    Michael, FWIW the assumption of a rational man in economics is pretty dated. Much if not most of the best economics research in the past several decades has started from the premise that people have only “bounded” rationality at best.

    I don’t say this to disagree with you – to the extent that I do, it’s only on the margins. It’s pretty clear that as a field of study economics is far too suggestible to ideological pressure. I say this as someone who may decide to get a PhD in it someday.

  • michael reynolds

    Maxwell:

    Well, don’t let me discourage you from that PhD, you might be the guy to take it from straight-up voodoo to at least the level of alchemy.

    I referenced the rational man because he’s appeared here in previous threads, causing my head to explode. Of course that may be in part my prejudices as a fiction writer. If rational man ever appears it’ll be the end of my career.

    Hamlet, starring rational man:

    Act 1:
    Hamlet: Wow, must have eaten some bad herring. Thought I saw my dead Dad there for a minute. Where’s the Pepto?
    The End.

  • steve

    I thought Mish’s three causes were exceptionally stupid. You might as well say greed and stupidity caused the crisis. How long have we had fractional lending? OTOH, I will give you credit for sifting through Mish’s screeds.

    Steve

  • Dave,

    I think I might have a comment in the spam filter.

  • john personna

    Michael, there are varying degrees of stupid in economics.

    At its most defensible it is narrative history, and that is useful. Those cross-country comparisons work on that level. They are not at all the same as the other extreme … say the predictions for GDP or unemployment five years out.

    I can’t remember now when it was Tango wanted to refuse all national comparisons … but that was also pretty stupid.

  • Drew

    “…arrived at what I think can only be considered a cop-out: everybody’s to blame—you, me, Republicans, Democrats, the Fed, regulators, Congress, bankers, consumers, foreign investors, everybody. Such a finding provides no clear guidelines for action. It is oracular rather than analytic.”

    I’m glad you wrote that, for that was precisely my reaction. I guess its the former engineer in me that forces me to see things diferently than most. I reflexively look for structural root causes.

    Hence, while acknowledging the role of uncrupulous mortgage originators and banking securitizers, I find them just a cog in the whole machine. (The analogy: blaming Wall Street greed is like blaming airplane crashes on gravity is beautiful. Greed, like gravity, is ever present and not new (or unique to Wall Street). But there had to be preceding events that unleashed greedy behavior, or gravity.)

    Hence, I’ve always pointed toward the catalyst, the raw material. And what was that? Housing demand, and the attendant mortgage financing. If you don’t have that, you don’t have all that followed.

    What were the sources of housing demand and (non-conventional) mortgage volume? CRA, Fannie and Freddie. That will always be my root cause, at least in the US.

    But one must acknowledge the non-US (primarily European) boom. I think this is where EZ credit in the US and elsewhere comes in. Further, its not like manias, or bubbles, are not noticed in disparate geographies.

    Once the ball was rolling, yes, we see a number of failures. Commercial banks enabled to be securities dealers through G-S. Excessive leverage. Unscrupulous mortgage originators and securitizers………………….and greedy home buyers. (How politically incorrect!!) Bamboozled regulators. Yes, its all true. But all of these issues and motivations would have been inactionable without the residential housing mania and mortgage financing. (After all, did we see the same in other time-financed assets, like cars or boats? No.)

    I do have to say this. Hennessey and his fellow minority observers made the right point. If we just want to make financial institutions the convenient whipping boys it will do nothing to prevent the next bubble. Nothing. Freddie and Fannie are out there irresponsible as ever. Dodd and Frank are trying to rescue their soiled place in history by putting forth exculpatory legislation. Greedy and incompetant mortgage holders are being bailed out by the taxpayers. Alas, I see nothing in the report that says that bad credit extension is bad credit extension – today as it was in 500 BC. There is your root cause.

  • michael reynolds

    Andy:
    Thanks for that. When his kids hit puberty he’ll attempt the screams and threats approach. Also doesn’t work, but it can be emotionally satisfying.

  • Do you really think that is an original question Steve? Surely you’ve been around for the last few years when the choices were pretty much break big things up to small things that can fail, or regulate big things so they don’t.

    There was no choice John. I see you still aren’t thinking.

    Michael,

    The causes are pretty easy to see:

    1. Low interest rates (the Fed).
    2. Big push for more home ownership (the Congress and President)
    3. Regulatory failure.

    These are, in simple terms, the ingredients for our problem. The first two are fairly simple to understand. The third encompasses a bit more than might appear.

    The third one would include incidents like long term capital management. The failure to properly regulate new financial instruments. I was reading quite a bit about the credit default swaps and how poorly regulated that market was. Could that have been a contributing factor to the bubble? Sure. One paper I was looking at had a flow chart for the mortgage process and it was astonishingly hard to follow and the possibilities for issue with moral hazard, adverse selection, hidden information, etc. were peppered throughout. Arnold Kling wrote about this. Back in the “old days” when you wanted a house you went to the bank with a 20% down payment. Now…now you don’t even need to state your income.

    Lots of companies probably thought they were covered too. Why we have hedged using CDS. But if everyone bets the same way, entirely possibly IMO in equilibrium, then you could have lots of people coming up bust. Whoops. Now you have set yourself up for a nice failure cascade. That was the fear with Long Term Capital Management and we doubled down on that mistake in the years since then.

    Steve is ravin’ because it calls out that lack of regulation.

    You know, I don’t think even a 120mm depleted uranium sabot round could penetrate your cranium.

    Michael, FWIW the assumption of a rational man in economics is pretty dated. Much if not most of the best economics research in the past several decades has started from the premise that people have only “bounded” rationality at best.

    True, now information is as much a constraint as one’s budget. If you don’t know that a good has a lower price at another store you wont be able to go and buy it at the lower price. Does that make you irrational? No. You could argue for searching, but searching has costs, or another way to put it there is a rational reason for some level of ignorance.

    Also some research is suggesting even additional movement away from Homo economicus based on the application of evolutionary theory in economics, e.g. Homo reciprocans.

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